Rout in emerging markets the start?

London - The flight of investors from the once-booming emerging markets they previously favoured with $7 trillion-worth of inflows may have only just begun.

It is mainly retail investors who have packed their bags and moved on to date. If and when big institutional firms join in, there is a risk of wholesale capital flight.

Signs of China slowing down and the global impact of a wind-down in US monetary stimulus - effectively draining money from the system - have been particularly punishing in emerging economies dependent on external financing.

Currencies in Turkey, Argentina and Russia have hit record lows, for example, lifting safe-haven yen, Swiss francs and US Treasuries in a sign of global contagion.

Such moves are crucial factors for foreign investors because exchange rate losses can easily wipe out any gains in stocks bonds in the high-yielding emerging world.

However, data on capital flows shows many long-term investors have either stuck with, or even added to, their emerging holdings. The outflows of over $50 billion seen since 2013 have largely been driven by retail investors.

But fears are that at some point the big investors will be forced to cut losses and run as the effect of falling currencies becomes too painful to bear.

And emerging stocks are the worst performer in global markets this year, having lost 4 percent.

But investor positioning so far seems far from extreme.

CrossBorder's emerging market risk appetite index, measured by normalised weightings of investors in equities less bonds, stands at a moderate -3, the lowest only since August and ca far cry from the -40 seen in 2012.

“What we haven't seen in emerging markets is major currency devaluation, a run on government debt or ratings downgrades. Any combination of those would suggest humiliation trade (a complete giving up of the asset class) is taking place,” said John Bilton, European investment strategist at Bank of America Merrill Lynch.

SUDDEN STOP

Now investors may need to be braced for further outflows.

The Institute of International Finance expects capital inflows into emerging markets, which include buoyant direct investments, to fall more than 3 percent to $1.029 trillion in 2014 - the lowest since at least 2009.

Portfolio equity flows are forecast to be down $17 billion.

World Bank warned earlier this month of the risk of a sudden stop in capital flows for emerging markets, a point which was discussed by the International Monetary Fund as well.

The bank said long-term interest rates are subject to a sudden rise of as much as 200 basis points under a scenario of disorderly adjustment when super-easy Western monetary policy begin normalising.

This could cut financial inflows to developing countries by as much as 80 percent for several months.

In such a case, nearly a quarter of developing countries could experience sudden stops in their access to global capital, throwing some economies into a balance of payments or financial crisis, the Bank said.

Stephen Jen, managing partner of SLJ Macro Partners, says emerging markets will have seen the worst - which involves currencies falling a further 10-15 percent - when the rising US 10-year yield reached 4 percent.

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